What Is the Difference Between Prop Trading and a Hedge Fund?

At first glance, there may seem to be no major difference between prop trading firms and hedge funds, both:
•    trade on financial markets
•    make profits from successful investments

 

 

They are designed to outperform traditional financial organizations like banks. However, the major difference lies in how the firm is financed:

 

 

• prop trading firms trade with their own funds.

 

• hedge funds use clients’ money for trading.

 

 

This fundamental distinction shapes the rest of the differences, including the legislative framework and organizational structure. Most importantly, it significantly affects the cooperation between the firm and traders. This latter feature deserves a detailed discussion.

 

Contents 

 

 

•    What about competition? A Prop trader vs. Hedge Fund trader

 

•    Prop trading – a shortcut to Premier league

 

•    Comparing the Revenue

 

 

What about competition? A Prop trader vs Hedge Fund trader

 

 

How do you become a Hedge Fund trader? You should be an experience investment banking person, or you should have a CFA certificate of financial analysts. Proper education and experience are key in your career as a Hedge Fund trader. Hedge Fund recruiters often seek out students from the Charted Financial Analyst (CFA) institute But what if you lack a genius-level mathematical background? To impress financial leaders, you must possess strong financial and communication skills.

 

 

As a hedge fund trader, much of your work involves sifting through vast amounts of information and creating financial models to generate trading ideas. You need to get your research approved by superiors and prove your accuracy. This role often demands 50-60 hours of work per week. If you can't meet the qualifications, you might have to step aside.

 

 

Quite a different situation you have in prop trading. Prop traders don’t need to prove themselves to others. They have already demonstrated their consistency by passing a challenge, which serves as an entrance exam.

 

 

A prop trader can choose:

 

 

1. Trading ideas,
   
    
2. Trading timing,
   
    
3. Their own workload.
   
    

While they must adhere to risk management rules, prop traders can work comfortably and enjoy trading to receive their payouts. These payouts will grow as they scale their trading accounts, akin to a growing startup but expanded with third-party funds and profit-sharing.

 

 

Prop trading – a shortcut to Premier League

 

 

Everybody wants to play in the Premier League.

 

 

For a hedge fund, this means becoming a portfolio manager with their own team. However, first, you must earn a CFA certificate, which takes about three years. You also need experience in investment banking. If you secure a job at a hedge fund, you'll need an additional 2-3 years of working for minimal salary to build a positive trading record. Your reputation becomes key to attracting new clients. Overall, it takes about 5-6 years of hard work to reach this level.

 

 

In prop trading, to be a top trader means managing up to 5 funded by prop firms trading accounts, each worth several million euros.

 

 

A novice prop trader needs to spend 2-3 months developing their first trading strategy, which includes time management, trading patterns, and risk management. After this, they need another month to prepare for their first challenge and then 5-6 months to scale up their trading accounts and manage 3-4 new accounts funded by prop trading firms. Overall, it takes about 12 months to reach the top in prop trading, significantly less than the 5-6 years required in hedge funds.

 

 

Comparing the Revenue of prop trader and Hedge Fund trader

 

 

Hedge funds are sophisticated structures. They typically charge a 2% management fee and take 20% of the profits. While this might sound substantial, consider the numbers: the average return of hedge funds in 2021 was 5%, whereas the S&P 500 index rose by 26%. The top ten hedge funds made slightly above 10% returns.

 

 

This doesn’t mean that a portfolio manager with $10 million under management will pocket $200,000 (2%) and another $500,000 (5%) from the profits. Hedge funds have numerous other expenses, including personnel costs. Thus, the actual reward is much less than one might expect.

 

 

Prop trading offers a transparent payoff system. A trader can earn between 60% to 90% (80% on average) of the profit from their account. At SpiceProp, traders can receive payouts every 14 days, unlike hedge funds, where payouts are typically quarterly. A prop trader managing $10 million in funded accounts with a return of 50-60%, or 4-5% monthly, could achieve $4.0-4.8 million in annual net revenue.